The Hidden Risks of Passive Investing

It is no secret that investment dollars have been shifting from actively managed investments to passively managed investments (i.e., Index Funds). There’s one number that explains a good portion of this phenomenon: 13.80%. The compounded annual growth rate (CAGR) of the S&P 500 Index over the last 15 years ending December 31, 2024, was 13.80% per year. This high rate of return has given birth to, among other things, an explosion of exchange-traded market index funds seeking better performance.

The Rise of Passive Investing and Potential Risks

It is also no secret that investors have gone beyond merely shifting a portion of their portfolios to a bevy of low cost index funds - they have moved millions upon millions of dollars into passive mutual funds and asset allocation models.

I believe many of these investors have made their decisions to move into passive investments based on cost savings and achieving index returns, without fully understanding the long-term implications of their choices. This has the potential for long-term disappointment as a result. For example, a 2018 research study prepared by the Natixis Center for Investor Insight revealed that 64% of those polled believe that their index funds are less risky than active funds, and 71% think that index funds will help them minimize losses in down markets.

In reality, passive funds have no built-in risk management, and they have become more and more risky over time, which is the exact opposite of what passive investors believe. An example of this would be the growth of technology stocks within the S&P 500 Index. At 29.3%, Technology is at its highest proportion of the S&P 500 since 2000, when the Internet Bubble popped and the market began a three-year losing streak. (The technology sector has the most volatility of any sector within the Index.)

Most investors have no idea that almost thirty percent of their investment in the Index is in one industry, and have no idea just how badly bear markets are apt to hurt their net worth, as in the Great Financial Crisis or the dot.com bubble of the late 1990s.

Passive Investing has become Passive Allocation

The more worrisome trend, in my view, is the shift to static asset allocation and other passive strategies, rather than the shift to index funds, per se. This can have a more powerful, negative effect on long-term investment results.

For example, in a landmark paper published in 1986, “Determinants of Portfolio Performance”, Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower concluded that asset allocation is the primary determinant of a portfolio’s return, and in fact, it was 90% of the reason for a portfolio’s return. The “Brinson Study", as it is referred to, was revisited by Gary Brinson in 1991 and yielded similar results.

A more simplified conclusion from the study is that 90% of the return in an investor’s portfolio will be determined by the mix of stocks, bonds, commodities, currencies, and cash, while only 10% will be determined by which individual stocks or investment funds are chosen within each category, or the costs associated with purchasing them.

In 1997, William Jahnke published a critique of The Brinson Study and concluded, "Static asset allocation solutions are inferior to analytically linking, forward-looking, active asset allocation solutions. As an investor’s circumstances, the economic environment, and market conditions change, so also should the investor’s asset allocation.”

Another widely cited study of pension plan managers said that 91.5% of the difference between one portfolio’s performance and another’s performance is explained by their asset allocation.

In other words, returns are based on "being in the right place at the right time" over the long run. The returns by asset class in the past 10 years can be seen in the chart below.

As you can see, it was far more important to have avoided Bonds (AGG) and to have owned US Stocks (ONEQ, SPY, DIA, IWM) and Commodities (USCI) than it was to have chosen a particular stock or fund.

Yet, investors with a passive asset allocation strategy not only held a fixed amount of bonds for the entire decade, but they also sold their stocks and commodities to purchase more bonds when they rebalanced their accounts. This reduced their gains and increased their losses. Passive asset allocation dragged the 10-year investment portfolio returns down by its very nature.

Being passive as an allocation strategy is bothersome. It looks more like an "I-give-up strategy" than a means for optimizing returns. Oddly enough, it was Mao Tse-tung (who was hardly a capitalist) who famously stated, “Our goal is to make our opponent passive”. Therefore, this begs the question, "What are investors missing when they commit to passive investing as a way to protect and grow their capital?"

To begin with, there are thousands of indexes and even more index funds that track them. How do you choose the best one for your situation? If you do all your own research to select an index fund, you have, in essence, become an active manager. Few individual investors have the time, or more importantly, the expertise for this.

Markets, by nature, move up and down. Sometimes down comes over 2-3-5 years, and sometimes it comes in a single, staggering chop. Who steps in to mitigate the damage, and who takes action to re-engage once things have settled down? That would be the individual investor once again.

Finally, there is the issue of the tax ramifications of passive investing. Index funds and passive asset allocation create transactions regularly through constant rebalancing. This causes batches of buying and selling, which causes capital gains to be realized and distributed to the index fund shareholder at the end of the year, regardless of the consequences.

Investors need to spend more time understanding their investment strategy, asset allocation, and investment selection to be prepared for the multiple risks that come along with it. This will improve the odds of reaching their long-term goals as well as provide a basis for course corrections, as well as stick-to-it-ness when the time arrives.

If you lack the time and expertise to actively allocate your investments and are sensitive to the potential pitfalls of passive investing, a good place to start is to speak with an experienced financial advisor who can act as an active asset allocator.